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| Risk & Reward: Crude Investments |
Energy Alternatives: The Master Limited Partnership
Eileen Gunn
11/01/2004
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Those of us seeking to capitalize on positive trends in the oil and natural gas
markets, but who are hesitant to own such fickle commodities for 10 years, may
opt for more liquid, publicly traded investments in the energy sector. Master
limited partnerships (MLPs) are one such option. They are publicly traded
companies (we own units, not shares) that deal in natural resources such as oil,
gas and timber.
MLPs are not quite a stock and not quite a bond. “They are
their own asset class,” explains Mark Easterbrook, an analyst with RBC Capital
Markets in Dallas, and that creates some management issues. However, with their
reliable income, relative liquidity and limited direct exposure to commodity
prices, they offer a different energy investment vehicle.
The best MLPs are
in businesslike pipelines that benefit from the strong demand that is spurring
oil and natural gas prices upward, but that are not dependent on those high
prices to do well. According to Easterbrook, these companies pay no taxes and
hand out up to 90 percent of their cash flow to investors via quarterly
distributions. Consequently, they are attractive to those of us interested in
energy’s upward trends and who want substantial current income from our
investments.
Like many energy-related investments, MLPs have done well
lately. RBC reports its MLP index returned 22.7 percent over the 12 months
ending July 9 (the most recent data available), compared with the S&P 500,
which gained 13 percent, and the 10-year Treasury index, which lost 1 percent.
Meanwhile, cash distributions for the group rose 4.2 percent in the first half
of 2004.
MLPs differ greatly, says Easterbrook, who recommends those that
store and transport refined products (gasoline, jet fuel, heating fuel) bound
for end markets. These MLPs benefit from the long-term demographic trends—such
as America’s shift toward bigger homes and cars—that are boosting demand for
fuel, and they tend to remain the most stable through commodity price swings.
“Look for partnerships focused on geographic regions where there is population
growth, like the Southwest, the Southeast or the Rockies,” Easterbrook says. Two
firms that top his recommended list, Kinder Morgan Energy Partners and Magellan
Midstream Partners, fall into this category.
Other companies own pipelines
that carry raw oil and gas away from the wells. While their volume-based fees
stay the same regardless of what commodity prices do, should those prices fall
low enough that people cut back on drillings, these companies could see demand
for their services fall. One such company, GulfTerra Energy Partners, a
Houston-based firm Easterbrook tracks, owns a network of oil and gas pipelines
and maintenance platforms across the Gulf of Mexico.
At the riskier end of
the spectrum, a few MLPs handle propane, which is very volatile and seasonal (it
does better in winter), Easterbrook says.
When sizing up an MLP, consistent
growth in the quarterly cash payout is a sign of a robust business. “Only one
MLP that cut its distribution came back and did well. Usually when they do that,
it’s the first step toward filing for bankruptcy or being acquired at a low
price,” Easterbrook explains.
Investing in MLPs in a rising interest-rate
environment can be tricky. “Rising rates usually signal that the economy is
good, which tends to mean the companies are piping more oil and gas and doing
well,” Easterbrook says. That often means increasing their distributions. The
trouble is that when Treasury rates go high enough, the income-seekers flock
from MLPs into bonds, which pushes down the companies’ unit prices and drags
down overall returns. “Bonds are safer and simpler, so why not do that instead?”
asks Christopher Edmonds, director of research at Pritchard Capital Partners in
Atlanta. “As long as you hold a bond until maturity, you don’t have the price
risk that you have in MLPs.”
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